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Cultural Capture and the Financial Crisis Preventing Regulatory Capture Special Interest Influence and How to Limit It Edited by DANIEL CARPENTER Harvard University DAVID A. MOSS Harvard University Cambridge University Press Not for sale or distribution. 32 Avenue of the Americas, New York, NY 10013-2473, USA Cambridge University Press is part of the University of Cambridge. It furthers the University’s mission by disseminating knowledge in the pursuit of education, learning, and research at the highest international levels of excellence. www.cambridge.org Information on this title: www.cambridge.org/9781107646704 C The Tobin Project 2014 This publication is in copyright. Subject to statutory exception and to the provisions of relevant collective licensing agreements, no reproduction of any part may take place without the written permission of Cambridge University Press. First published 2014 Printed in the United States of America A catalog record for this publication is available from the British Library. Library of Congress Cataloging in Publication Data Preventing regulatory capture : special interest influence and how to limit it / [edited by] Daniel Carpenter, Harvard University, David A. Moss, Harvard University. pages cm Includes index. ISBN 978-1-107-03608-6 (hardback) – ISBN 978-1-107-64670-4 (pbk.) 1. Deregulation – United States. 2. Trade regulation – United States. 3. Interest groups – United States. I. Carpenter, Daniel P., 1967– II. Moss, David A., 1964– HD3616.U63P74 2013 338.973–dc23 2013008596 ISBN 978-1-107-03608-6 Hardback ISBN 978-1-107-64670-4 Paperback Cambridge University Press has no responsibility for the persistence or accuracy of URLs for external or third-party Internet Web sites referred to in this publication and does not guarantee that any content on such Web sites is, or will remain, accurate or appropriate. Cambridge University Press Not for sale or distribution. 4 Cultural Capture and the Financial Crisis James Kwak1 In 1992, Barbara Smiley, a resident of California, sued Citibank, alleg- ing that it violated California law by charging late fees to her credit card account.2 During the litigation, the Office of the Comptroller of the Cur- rency (OCC) – the primary regulator for national banks such as Citibank – issued a proposed regulation specifying that late fees were “interest”3; under federal law,4 this meant that Citibank was bound solely by the law of the state where its credit card subsidiary was situated – South Dakota.5 When the case was appealed to the Supreme Court, twenty-five states and sev- eral consumer organizations signed onto briefs supporting Smiley; fifteen states, the American Bankers Association, and the OCC supported Citibank. The Supreme Court ruled for Citibank, deferring to the OCC.6 The Court acknowledged but discarded the fact that the OCC seemed to have issued the regulation because of the ongoing litigation,7 endorsing the ability of a federal agency to issue regulations to sway pending litigation in favor of the companies it supervised. 1 Associate Professor, University of Connecticut School of Law. I would like to thank Chris- tine Jolls, the other authors represented in this volume, and two anonymous reviewers for helpful suggestions. 2 Smiley v. Citi bank (South Dakota), N.A., 517 U.S. 735, 738 (1996). 3 Office of the Comptroller of the Currency, “Interpretive Rulings,” 60 Fed. Reg. 11924, 11929 (1995). 4 Section 85 of the National Bank Act, 12 U.S.C. § 85, interpreted by Marquette National Bank of Minneapolis v. First of Omaha Service Corp., 439 U.S. 299 (1978). 5 Citibank located its credit card issuing bank in South Dakota because of favorable reg- ulation offered by that state. Robin Stein, “The Ascendancy of the Credit Card Indus- try,” Frontline, November 23, 2004. Available at http://www.pbs.org/wgbh/pages/frontline/ shows/credit/more/rise.html. 6 Smiley, 517 U.S. at 739. 7 Ibid., 741. 71 Cambridge University Press Not for sale or distribution. 72 James Kwak The OCC’s intervention in Smiley v. Citibank wasjustonepartofa sweeping campaign to lift constraints on national banks, allowing them to enter new businesses while blocking efforts by states to rein them in.8 The OCC, in turn, was just one of several federal agencies that spent most of the past two decades fulfilling the wishes of different segments of the financial sector. The Federal Reserve issued a series of decisions enabling banks to expand into the securities business9 and later declined to enforce consumer protection statutes against the nonbank subsidiaries of bank holding companies.10 All four major banking agencies (the Federal Reserve, the OCC, the Office of Thrift Supervision [OTS], and the Federal Deposit Insurance Corporation [FDIC]) relaxed the capital requirements governing structured financial products, enabling banks to ramp up their securitiza- tion businesses without setting aside large amounts of capital.11 The Secu- rities and Exchange Commission (SEC) allowed major investment banks to use their internal models to calculate their net capital, giving them greater flexibility to effectively increase their leverage;12 in exchange, the banks gave the SEC new oversight powers that went essentially unused.13 The OTS was perhaps the worst offender, seemingly engaging in blatant efforts to attract fee-paying regulatory “customers” with the promise of lax regula- tion.14 Several of these policies were vigorously contested at the time, as was the OCC’s position in Smiley. In 2003, when the OCC issued two proposed rules that would expand federal preemption of state law, it received more than 2,700 comment letters. The vast majority of the non-form letters opposed the proposed rules, including a majority of letters from every category of 8 Steven P. Croley, “Public Interested Regulation,” Florida State University Law Review 28 (Fall 2000): 75–84; Adam J. Levitin, “Hydraulic Regulation: Regulating Credit Markets Upstream,” Yale Journal on Regulation 26 (Summer 2009): 152–5. 9 Simon Kwan, “Cracking the Glass-Steagall Barriers,” Federal Reserve Bank of San Francisco Economic Letter 97–08, March 21, 1997. 10 Binyamin Appelbaum, “Fed Held Back as Evidence Mounted on Subprime Loan Abuses,” Washington Post, September 27, 2009. Available at http://www.washingtonpost.com/ wp-dyn/content/article/2009/09/26/AR2009092602706.html. 11 Corine Hegland, “Why It Failed,” National Journal, April 11, 2009, 12–20. 12 Securities and Exchange Commission, “Final Rule: Alternative Net Capital Requirements for Broker-Dealers That Are Part of Consolidated Supervised Entities,” 69 Fed. Reg. 34428 (2004). 13 SEC Office of Inspector General, SEC’s Oversight of Bear Stearns and Related Entities: The Consolidated Supervised Entity Program, September 25, 2008. 14 Binyamin Appelbaum and Ellen Nakashima, “Banking Regulator Played Advocate Over Enforcer,” Washington Post, November 23, 2008. Available at http://www.washingtonpost .com/wp-dyn/content/article/2008/11/22/AR2008112202213.html. Cambridge University Press Not for sale or distribution. Cultural Capture and the Financial Crisis 73 respondent except “bank industry [other].”15 The OCC made some changes in the final rule, but refused to budge on the core preemption issue.16 Many of these policies also contributed to the financial crisis that began in 2007. Deregulation of financial markets enabled financial institutions to spawn new types of mortgages that fueled the housing bubble, manufacture enor- mous volumes of securities that became toxic when the bubble collapsed, magnify and concentrate risk through the use of customized derivatives, and lever up with short-term debt. Policies that were favored by the financial sector because they increased profits in the short run ended up making the financial system more fragile and imposing widespread losses on society. CAPTURE? At first glance, federal regulation of the financial system over the past two decades seems like a case of regulatory capture, in which agencies do the bidding of industry without regard for the public good. However, there is a problem with this picture, which can be identified by focusing on the definition of capture in this volume (slightly shortened): “a process by which regulation . is consistently or repeatedly directed away from the public interest and toward the interests of the regulated industry by the intent and action of the industry itself.” Most importantly, it is difficult to prove that the deregulatory policies pursued by these agencies were clearly not in the public interest as knowable at the time. In retrospect, given the economic and fiscal consequences of the financial crisis, it seems obvious that policies that increased the likelihood or severity of the crisis were not in the public interest. However, two defenses can be made against this indictment. First, bad outcomes are not proof of bad policy, because the outcomes of policies are probabilistic. It is theoretically possible that the recent financial crisis was a fluke accident17 and that the true expected impact of these policies on the public interest was positive – just as a football team’s failure to gain a first down on fourth-and-one does not mean that going for a first down was a bad decision.18 Second, many agency 15 Government Accountability Office, OCC Preemption Rulemaking: Opportunities Existed to Enhance the Consultative Efforts and Better Document the Rulemaking Process,October 2005, 30–6. 16 Ibid., 36–40. 17 For the record, I am highly skeptical of the “once-in-a-century flood” theory of the financial crisis. 18 Indeed, Romer shows that teams should go for a first down on fourth-and-one
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